UPDATE 1-Highland Capital liquidating funds

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By Svea Herbst-Bayliss

BOSTON, Oct 16 (Reuters) - Facing heavy losses and deteriorating market conditions, Highland Capital Management said it will shut down two hedge funds which built their records by investing in ailing companies.

Highland Capital wrote to investors on Wednesday that it will liquidate the $1.5 billion Crusader Fund and the $500 million Credit Strategies Fund.

Reuters obtained the letters on Thursday.

The Highland funds are the latest casualties in the once high flying $1.9 trillion hedge fund industry where cratering financial markets plus recent restrictions on short selling -- a popular trading technique among hedge funds -- left the industry with its biggest-ever losses.

"Unprecedented market volatility and disruption to the financial system continue to pose huge challenges, with conditions having deteriorated significantly over the past 60 days and in particular over the last two weeks," partners at Dallas-based Highland Capital told their clients.

Investors received the news hours after the Dow Jones Industrial Average tumbled 7.9 percent on Wednesday amid talk that prominent hedge funds suffering heavy losses were dumping stock to meet investors' demand for their money back.

The average hedge fund lost 10 percent in the first nine months of the year, according to Hedge Fund Research data. Some prominent funds are down even more with investors saying Citadel Investment Group's flagship Kensington portfolio tumbled 15 percent in September alone.

Highland Capital, which still manages three hedge funds as well as other strategies, told investors that its managers hope to sell 40 percent of the Crusader portfolio over the next 12 months. The remainder will be paid in a period of up to four years, the partners wrote. The long time-frame illustrates just how difficult it is to exit positions now.

The smaller Credit Strategies Fund hopes to sell 20 percent of its portfolio over the next six months with another 20 percent sold off in the six months after that. Another 15 percent will be sold in the six months after that and the rest paid in a period of up to three years.

Highland investors began getting nervous as early as this summer when they demanded back millions of dollars after losses at the roughly $2 billion Crusader fund swelled to about 15 percent for the year. A schedule for repayments was worked out at that point. In its heyday, Crusader managed roughly $3 billion.

Since the summer conditions quickly worsened for Highland plus thousands of other hedge funds as banks stopped lending them money and U.S. regulators briefly forbid shorting of nearly 1,000 financial services companies.

Shorting, where managers borrow stocks they expect will decline in value and then repay their loans for less at a later time, is used both to make bearish bets and to hedge big portfolios. It was a tool heavily used by hedge funds to deliver strong returns in most markets.

"The environment is one where the fundamental tools to manage (the Crusader and Credit Strategies Funds), hedging, shorting and financing are highly constrained, and in some cases unavailable," Highland partners told their clients.

The Highland news illustrates a stark trend in the once booming hedge fund industry where endowments, pension funds and wealthy individuals pumped so much new money that assets doubled to $1.9 trillion in three years.

Now investors and industry analysts are predicting that hundreds of hedge funds will collapse in the second half of the year as investors are rushing for the exits. (Reporting by Svea Herbst-Bayliss, editing by Gerald E. McCormick, Dave Zimmerman)